Part 1 of two-part series: History is full of examples of financial institutions failing and economies collapsing when the public loses trust in the banking system

Activists protest at an anti-bailout demonstration outside the Cypriot parliament in the capital Nicosia, in April. What happened there is an object lesson on what can happen when people lose their trust in the banking system.

Photograph by: Petros Karadjias
, AP

The history of banking might be defined as a history of trust.

A depositor hands over his or her money to a third party, who promises to safeguard it. Then, on demand at some future date, the third party returns it in full measure.

In more recent times — relatively recent in the long history of a financial system at the heart of modern civilization — the deposit might be loaned out to yet another party, with the bank assuming all the risk. The depositor earns interest on the transaction, but with return of the deposit guaranteed on demand.

It has become a critically important process in the modern financing of state enterprises, industrial development, technological innovation, scientific research and myriad consumer requirements that are small individually but vast collectively. For most of us, these transactions range from borrowing money to purchase a dwelling to the credit-line that enables switching a household to energy-efficient lighting, or buying a new refrigerator or hybrid car to replace the electricity hog and the gas guzzler.

Former Bank of Canada governor Mark Carney pointed out the importance of public confidence earlier this year when he observed that “trust arrives on foot, but leaves in a Ferrari.”

This is precisely why everyone should be paying close attention to the emotional fallout from the Cypriot banking crisis. Financial institutions in the small Mediterranean island state were side-swiped by defaults in Greece, faced with its own economic crisis.

The European Union’s bailout proposal for Cypriot banks last March required the government of Cyprus to impose a levy on all bank deposits. Every depositor would lose six per cent — people with deposits of more than 100,000 euros would lose 10 per cent.

Shock and dismay reverberated through the Cypriot economy. Trust in the security of bank deposits had just been blindsided by bureaucrats. People began withdrawing funds, assuming that keeping it in a sock might be safer than leaving it in the bank.

This process echoes similar runs on bank deposits when trust unravelled. They occurred in the 1930s, in 1907, and in 1873 — and there is even evidence of similar activity more than 1,600 years ago. Archaeologists have noted the discovery of unusually large numbers of buried coin hoards, particularly at the fringes of Roman authority, which coincide with widespread banking failures and social breakdown in the fourth century.

Cyprus had to cap daily withdrawals at 100 euros to prevent a panic that would have collapsed the banking system. In an attempt to restore stability, the European Union revised the proposal to protect small deposits under 100,000 euros.

But the spectre of doubt was out of the crypt.

When Canada’s government proposed legislation requiring troubled banks to tap their own reserves instead of looking for help from the taxpayer, there was such concern over the integrity of deposits that federal Finance Minister Jim Flaherty had to pledge that amounts under $100,000 would not be touched.

Will these belated assurances slow the Ferrari as it squeals away, leaving trust as the hit-and-run victim? Who knows? Banking has proved a durable institution, reborn amid the ashes of its own excess on numerous occasions.

Banks collapsing under mounting deficits of squandered trust is an old story. It has happened in ancient times, in the Medieval, the Renaissance, during the Enlightenment, and in the 19th, 20th and 21st centuries.

We have had financial bubbles, implosions and subsequent depressions over tulips, privatizing public debt, railways, agricultural commodities, gold supplies, real estate, digital technology and even simply the romance of prosperity itself, which is nominally what led to the stock market crash in 1929 and subsequent bank failures.

Almost all of these economic catastrophes were triggered by faltering trust in the integrity and fairness of the banking system.

In the historic record, evidence of commercial credit and financing first shows up on clay tablets inscribed with the 5,300-year-old financial records of what appears to be a family bank in the Assyrian empire; there are banking records in India from 4,300 years ago; and records of banks in Babylon, Persia, Greece in the Homeric era about 2,700 years ago.

Archaeologists have even recovered the names of some of these venerable institutions, their clients, and the often-vanished cities in which they conducted their financial transactions: The payment of 15 shekels of silver from the account of Ardu-Nama in the city of Ur, to Bel-Abdal-Iddin of Hurak; Nurashu and Sons conducting banking business in the city of Nippur; Sons of Egibi operating in Assyria, and so on.

This historic evidence points to prehistoric financial institutions that became established with — and perhaps helped in the financing of — the growth of the first city states, kingdoms and empires in the Middle East and India.

From Persia, banking practices spread across the Mediterranean. There were banks in ancient Greece — among the earliest evidence is a transcript from a court case alleging misappropriation of funds. A merchant depositor sued Pasion, a prominent Athenian banker, credited with the creation of a banking system that permitted Athens to finance its expansion, when the financier took advantage of political unrest and refused to return the money deposited.

How the court case turned out we don’t know, but we have the plaintiff’s eloquent, detailed and persuasive case because he hired the famous orator Isocrates to write his argument. The text was preserved as an example of flawless rhetoric, and scholars have been able to glean from it evidence of Athenian banking practice and judicial proceedings.

Alexander the Great’s empire was accompanied by a rapid expansion in banking. Some argue that the Hellenistic period altered financial history forever because it saw the first state bank established under the Ptolemies, descendants of the Macedonian general who installed himself as Egypt’s ruler after Alexander’s death.

When the Greek dynasty ruling Egypt recognized the power and profitability of private banks, they launched their own central bank. Its enormous success in stabilizing and codifying intervention in the market to advance state goals was not lost on Rome, Egypt’s chief commercial competitor in the Mediterranean.

Rome strictly regulated deposit banking, but also permitted less risk-averse credit banking in which associations could lend venture capital to the banks that were emerging as key components in the commercial, political and military organization of what arguably became the world’s most successful empire.

Similar developments occurred in China. Deposits, loans, credits, currency exchanges, long-distance financial transfers, and even paper money were well-established before the Mongol invasions in the late 13th century.

In the West, the failure of the banking system — characterized by corruption, greed and a degradation of institutional integrity — leading to debased currencies, rapid inflation and loss of public trust, signalled the end of Rome, some historians argue.

As trust — the essential lubricant — evaporated, depositors fled, banks collapsed, capital dried up, merchants were ruined, trade stalled, and the social landscape was so transfigured by the fifth century that subsequent historians were describing it as The Fall of the Roman Empire.

Yet banking proved such an indispensable institution that it resurrected itself in the so-called Dark Ages as kings and warlords gave themselves exclusive rights to mint currency — an idea adopted from Greece and Rome — thus ensuring their coinage wasn’t debased.

During the Middle Ages, even though the Christian church banned the charging of interest as usury, non-Christians proved convenient for currency exchange and for providing credit with which kings could wage war.

The genesis of our modern banking systems arose to finance the merchant princes of the great trading cities that comprised the rump of the Roman Empire — Venice, Florence, Genoa, Constantinople — and soon took root in the commercial opportunities that came with the rise of British, French, Spanish, Russian and German empires and their successors in the United States, the Euro block and the emerging economic powerhouses of China, India and Brazil.

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Activists protest at an anti-bailout demonstration outside the Cypriot parliament in the capital Nicosia, in April. What happened there is an object lesson on what can happen when people lose their trust in the banking system.

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